Here’s How Much Trump’s Tax Cuts Have Boosted the Market

Over the weekend, the proposed changes to the US tax code took one step closer to becoming reality.

If you’re like me, you probably have no idea about what Trump’s tax cut legislation involves, apart from a plan to cut US corporate tax rates from 35% to 20%.

But if you’re trying to work out the impact on the market, that’s about all you need to know.

Let me explain…

You’ve probably been surprised at the relentless rise of the major US stock indices, the Dow Jones and the S&P 500, this year. New record highs occur with rapid frequency these days.

That’s partly due to the improving global economic environment. As the Financial Review reported on Friday, global manufacturing activity is at the highest it has been in years:

Factories across the world were at their busiest for decades during November when a global upswing in economic activity and trade boosted manufacturing activity.

In surveys published on Friday, the Dutch manufacturing purchasing managers’ index for November hit a record high, the Italian index reported the strongest new orders in 17 years and Ireland’s the strongest rate of growth for 18 years.

Overall eurozone manufacturing expanded at the second-highest rate on record. The IHS Markit purchasing managers’ index for the currency bloc came in at 60.1. Anything above 50 indicates expansion, a reading beaten only by one survey in April 2000.

But the rise in activity was not limited to the eurozone: British factories were at their busiest in more than four years in November, the Japanese manufacturing PMI, also published on Friday, pointed to the strongest growth for 44 months, and South Korea recorded a 55-month high.

Clearly, the global economy is in the midst of a coordinated upswing. But that’s not the main factor driving US markets higher.

Trump’s proposed tax cuts are.

To explain why, let’s do some very simple valuation analysis.

Consider a US company expected to earn $100 million pre-tax in FY18. It’s after tax profit should therefore be $65 million ($35 million goes to the government).

Let’s assume the company trades on the same forward price-to-earnings (P/E) multiple as the S&P 500, currently 19.7.

That gives the company a market value of $1.2805 billion.

Now, assume the tax cuts pass and the company’s tax rate falls to 20%. Instead of paying $35 million in taxes, it will only pay $20 million.

It’s after tax profit rises from $65 million to $80 million. That’s a jump of 23%, a very handy profit boost.

If we then apply the P/E multiple of 19.7 to $80 million, we get a market value of $1.576 billion.

In other words, the proposed tax cuts have provided a 23% boost to expected future earnings. That’s massive. Throw in a booming global economy, extreme optimism about all things tech, and you can see why US markets have had such a good run this year. 

The question is, to what extent have Wall Street analysts factored the tax cuts into their future earnings forecasts? If they’re not factored in at all, then the P/E of the market falls to around 15.2x (assuming the tax cuts pass into law) which is not all that expensive.

If they are factored in however, then the market looks expensive.

I don’t know the answer to that. I suspect that it’s a bit of both.

The point I’m trying to make is that tax cuts can have powerful effects on company — and therefore market — valuations.

So if you think there is no substance behind the relentless rise in US stocks this year, think again.

Having said that, it doesn’t rule out a sizable correction taking place.

One of the oldest rules of the market is that investors ‘buy the rumour and sell the fact’.

This is another way of saying that the market prices in the impact of something before it actually occurs. In this case, the market has effectively assumed the tax cuts will pass into law and that company profits will get a boost down the track.

There are two scenarios to look out for here.

Firstly, if there are any major problems with passing the legislation, look out. That seems like a low probability, but it’s certainly a risk.

The other issue is far more standard. That is, when the rumour becomes a fact (that is, the legislation passes) traders will likely sell and take profits on the tax trade.

That’s because, by definition, the tax is now law and therefore in the price. The tax trade is over.

The other thing to take into account is that, if passed, the tax laws will take effect from 1 January 2018. It may be more profitable for investors to sell after that date. If so, look out for a New Year sell-off.

Either way, the thing to keep in mind here is that the prospect of tax cuts has been the driving force behind the recent market rally. And that’s about to end…

Regards,

Greg Canavan,
Editor, Crisis & Opportunity


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

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